Investing in Biotech

Investing in Biotechnology Stocks

A Primer on the Biotechnology Sector Easier to Understand than Tech Stocks

Rod Raynovich 11/3/2004

Biotechnology Background: Emerging Growth Area

Biotechnology – often referred to as the Life Sciences — is a significant growth sector of the economy, creating breakthrough therapies, medical devices and tools for biological research and drug discovery. A key primary investment driver to the industry is government sponsored funding through the National Institute of Health (NIH). NIH funding is currently running at $28 billion/year, up from $18 billion in 2000. Research spending for biopharmaceuticals currently exceeds $50 billion/year. Hundreds of billions are generated from product sales of pharmaceuticals, diagnostics, medical devices, vaccines and research tools.

Another key investment driver is U.S. venture capital (VC). VC investment reached peak levels of $93.9 billion in year 2000, according to Ernst and Young/Venture One. At the same time, VC raised approximately $4 billion for medical devices and healthcare services. Life sciences (medical devices and biotech) was a leading target of VC funding through 9 mos of 2004, totaling $15.3 billion.

And while other sectors of venture capital and equity markets have crashed, the biotech market has, in fact, remained quite robust. For instance, early in 2003, small cap biotechs with broad clinical pipelines, large market opportunities, and strong cash positions were the leaders in the 2003 stock performance. These small caps, which had raised significant amounts of capital during the booming financing season of 1999-2001, led the biotech market recovery because the 2003 IPO window had not yet opened up. Many of these already public companies were of excellent value. Subsequently worldwide biotech funding boomed later in 2003 with over $18 billion in financings (Ernst & Young 2004).

The Biotech Industry Has Reached A Product Growth Phase

More than 190 new biotechnology products have been approved for sale, according to Ernst and Young. Product sales have generated sales in excess of $20 billion among the top ten biotech companies, according to MedAd News (July 2004). The top five firms in order of sales include Amgen, Genentech, Serono, Chiron, and Genzyme. These were also among the first to receive FDA approval for a biotechnology product in the late 1980s to the mid 1990s.

In terms of new product development,this level of growth in product introduction gives biotech equal standing to the pharmaceutical industry. Indeed, many of the big pharma products have been developed in collaborations with small and large biotech companies.

What’s in the Pipeline and Can We See?

Biotech companies currently have about 370 drugs undergoing clinical trails. Beginning in October of this year, changes in the way data supplied should give the industry more transparency: there will be better disclosure of results from clinical studies from individual companies and an online database provided by the Pharmaceutical Research and Manufacturers (PhRMA) of America. This sould further buoy investor confidence, and interest, in the sector. This can help level the playing field for the average investor by affording access to the database of clinical trial results at all stages for those willing to spend the review time. It may also help circumvent “leaks’ regarding clinical trial data and thus minimize costly legal actions.

There was heavy M&A activity in 2003, and this is expected to continue in 2004-2005.

R&D collaborations will also continue, and this will likely result in lower and medium tier companies appreciating in value. Even if a company has no revenues and is not profitable, the company can realize significant value up the food chain. Licensing of IP is also a major driver of value.

The Playing Field

There are currently over 1000 publicly traded biotech stocks, most of which are traded on NASDAQ. However, due to tighter financial listing requirements many have been delisted and those are traded on the Pink Sheets or the Bulletin Board (.OB).

However, realistically there are about 100 stocks that are of sufficient size and trading volume to warrant investing or trading. An additional 300 or so public companies may have speculative appeal. Since the 1999-2000 investing “bubble,” many investment banks and brokerage firms have dropped analyst coverage of microcap biotech stocks. This could be an investment opportunity for savvy individuals.

How Investors Can Capitalize on . . .

There are about 7000 hedge funds and 7000 mutual funds in the financial community.

With all these institutions battling it out with ever more sophisticated computers and trading models it is becoming increasingly difficult to have a trading edge. One should explore the institutional impact on biotech investing and trading as much of the data is available from NASDAQ and Mutual Fund reporting. There are probably about 100 mutual funds and hedge funds that have a large impact on biotech investing.

A History Lesson In How To Pick A Winner

The biotech industry really got going in the early eighties with the first IPO in 1980 by Genentech, followed in the early eighties with the IPOs of Amgen, Biogen, and Genzyme. If one took a classical buy and hold approach and purchased only AMGN, BGEN, and DNA, then your return would be about 1000x. Since 1989, returns for Genentech and Amgen respectively are greater than 2000% and 10,000%. However, other investments in various biotech stocks could have been total wipe-outs.

Another approach would have been to purchase leading mutual funds in the early nineties and in that case the returns would be as follows.

Fig 1: Comparison of Vanguard and Fidelity Funds Since 1990

5 year Ave. Ann. ret

10 year Ave. Ann. ret

Fidelity Select Biotech (FBIOX)

4%

12%

Vanguard Health Care (VGHCX)

12%

20.5%

Other strong fund performers over three years annual return were State Street Health Sciences (SHSAX 18) at 13.11%/yr. and Fidelity Select Medical (FSMEX 20) equipment at 15.71%/yr.

The larger cap biotech ML Biotech Holders (Amex:BBH) trust was just under 100 in late 1999 and is currently at about 134, representing a 40% Total Return over a period of roughly 5 years.

FIG 2: BBH vs IBB

As can be seen by the biotech indices show above (the BBH and the IBB), the industry market capitalization has been a roller coaster ride since the bursting of the stock market bubble in 2000, but averaging in positions or buying at bottoms can yield total returns returns in the range of 30-50% over 5 years or 10% annualized return. The IBB index is much more volatile due to inclusion of smaller cap and more speculative stocks.

FIG 3: QQQ vs IBB

The chart also shows periods of extreme volatility where due to novel scientific themes such as genomics in 1999-2000, valuations reach extreme heights and speculative frenzies. Bear markets such as 2002, 1993 and 1984 collapse investments in the sector resulting in free falling small caps, fewer start-ups and almost no IPO’s.

Overall we have looked at an analysis of biotech indices such as the BBH (see Top Ten holdings) BTK and FBIOX (Fidelity Biotechnology fund ) and compared it to the NASDAQ and S&P 500 index over the past 5-10 years and concluded that the biotech performance outperformed the NASDAQ (BBH up 40% and QQQ down 50% over 5 years). The BBH also outperformed the S&P by more than 50%.

See chart below (BBH vs ^SPX).

FIG 4 BBH vs ^SPX

In conclusion, from this data we can see that a long-term, diversified investment approach to investing in biotech can provide better results than the NASDAQ index in general. This may be because there is strong continuous demand for cost effective health care and scientific breakthroughs for medical treatments.

We will discuss investment themes in the life sciences but the broad drivers of stocks in the biotech sector are as follows:

Steady investment by fund managers who put investors’ money to work, seeing biotech as one of the biggest growth engines during bull markets. Moreover investment bankers and venture capitalists see major opportunities to raise money for the hottest prospects.

IPO, merger and acquisition activity.

Themes that Support the Markets

The underlying theme for the growth of biotech companies is the development of products that treat major health problems in the areas of cancer, cardiovascular, inflammation/autoimmune and infectious diseases. Many new opportunities also exist to cut costs and address unmet healthcare needs in diabetes, opthalmology and drug delivery.

Some important themes that have driven biotech stocks in the past are reviewed briefly.

Cancer: 2004 saw the approval of two blockbuster products that can be used for the treatment of cancer: Genentech’s Avastin (Nasdaq: DNA) and Imclone’s Erbitux (Nasdaq: IMCL). Both products come with indications for colorectal cancer.

FIG. 5: 2004 Chart for DNA Genentech

Genomics: Genomics was the primary force behind the biotech bubble of 1999-2000. Human Genome Sciences (Nasdaq: HGSI) stock (see chart in Appendix) reached 100 in Q1 2000 as the promise of a new drug discovery paradigm would flow from understanding the genetics of disease. Fast forward to 2004, and HGSI stock is at 10 with no product revenues, the company has spent $900M on R&D, and it has mediocre product pipeline. Incyte (Nasdaq: INCY) pharmaceuticals, also a bubblicious stock, hit a high of 140 in Q1 2000 and has spent over $500M in R&D. Incyte is currently trading at around 7. Genomics and its latest buzzword proteomics still hold long-term promise but the path to success is slower and more expensive. For example, pharmacogenomics, the application of genetics on clinical development and improved drug efficacy, has shown to be a valid tool to qualify patients whose gene mutation make them more responsive to a cancer drug such as Novartis’Gleevec.
A new medical research discovery that holds promise is RNA interference (RNAi), an early stage technology that allows scientists to turn off genes and their proteins that may be implicated in disease.

FIG. 6: Ten Year Chart for HGSI (From Yahoo Finance)

Drug Discovery Tools: The late 90’s through early 2000 saw the development of new molecular tools for speeding up the drug discovery process. Better understanding of cell biology such as cell membrane receptors, signal transduction and DNA transcription led to a plethora of tools and companies that propelled deals between these new companies and larger biopharmaceutical companies. Some acquisitions resulted but overall the productivity gains from the new tools did not result in a paradigm shift to dramatically spur creation of new products. Many of the smaller cap tool companies subsequesntly morphed into product companies, but many pure plays are still around: ARQL, CIPH, CRA, EXEL, GLGC.

Small Cap Speculation: During bull runs and sector strength, high quality small caps and microcaps can provide excellent trading vehicles. Traders focus on scientific and product news, seasonality (Nov.-Jan.), balance sheet and stock RS/MO, looking at statistics like daily volume % movers. Keep in mind however that these stocks may well exceed fundamentals and actual technology value and have become captive to the traders. Deciding when to exit the position may be the hard part.

Trading and Investment Strategies

Biotechnology investing can be similar to technology investing but much more difficult to execute and can require considerable time investment for the following reasons:

Core technology and company valuation is driven not only by financials but by patents (Intellectual Property-IP), partners, clinical trial results and institutional holdings. Analysis can be very difficult, particularly the clinical development, without intense focus and some industry or medical background. Financial metrics are only one piece of the puzzle. IP can indeed the value engine of the company to drive deals and financings.

Institutional holdings such as hedge funds, mutual funds, and venture capitalists can control the momentum of the stock because of the small trading float and their greater awareness of potential strategic events in the company. Moreover, “like-mindedness”among hedge managers and VCs can result in volatile movements as they “gang-up” on a stock.

Themes and sentiment can have a greater impact on a stock’s momentum. For example at a major cancer meeting such as ASCO (American Society of Clinical Oncology) held every May, favorable clinical results can drive not only a specific company’s prospects but the whole cancer biopharmaceutical sector. During periods of strong MO “right brain” feeling for a stock transcends “left brain” analysis.

In a hot market such as 1999-2000 when everybody thought that genomics was going to result in breakthrough drugs, as well as in early 2004 when cancer therapies were being approved by the FDA, momentum investing was a key strategy used by many funds and individuals. Momentum investing in a nutshell involves following the chart, without overanalysis: “Don’t fight the tape,” in short. Microcaps also do well in a MO cycle as upside volume is driven more easily by rogue institutions.

In a bear market when small cap biotechs are out of favor because market sentiment focuses on fundamentals, volume dries up and stocks go into freefall because intrinsic value is the cash position and technology value, which may be known only to a select few investors. Seasonality can also be a factor. In general biotech stocks are hot during key scientific meetings when data is being presented and during the fall and early winter when investor meetings are scheduled.

Because of the potential volatility in the biotech sector, and the considerable presence of “fast money” that might be moving or controlling a stock, it’s wise to have a long-term, strategic approach to investing in biotech stock markets. Below we look at some potential strategies.

Buy and Hold/ Portfolio Allocation

The first decision that needs to be made is how much of your equity portfolio should be allocated to technology and health care including a portion of that in biotechnology.

A good starting point would be to buy two biotech and/or health care mutual funds and then dollar-cost average in on a few individual new investments at the appropriate time, trying to focus accumulating when the market is weak rather than piling in at the peak of bull-market periods. To complement these investments, one could buy a few large cap biotech stocks with reasonable valuations, 15%+ revenue growth and strong balance sheets.
See data in the Appendix for three of the top rated biotech/healthcare funds.

Overweighted Portfolio

If one chooses to be more aggressive in development of a biotech stock portfolio, then more time needs to be spent understanding life-science technology, following clinical development, reviewing financials, and tracking ownership. The next section will briefly introduce trading, analysis and tracking methodologies.

An aggressive portfolio needs to be balanced first with large caps and small caps. Small cap biotechs have the biggest profit potential in bull markets because value is realized with major clinical events, deal news and buy-ins by institutional investors. During a bull market in biotechnology, positive news on a company’s prospect can have a dramatic increase in a stock’s momentum. For a a small cap company, a Notice of Allowance of a patent can mean licensing and deal revenue, increased product revenues and potential of a buy-out. A good initial allocation is 70% large caps and 30% small caps, although rigid adherence is not really possible because there are also medium caps. The idea is to have at least 70% of the portfolio in larger cap companies that have product revenue, are profitable and strong balance sheets to fund big R&D budgets. The balance of the portfolio can be more speculative but with companies that have at least 2-3 yrs of cash to fund R&D and clinical programs.

Shorting

Shorting can be a dynamic tool for portfolio management but execution is beyond the scope of this paper. Biotech stocks are extremely volatile, particularly those below the top tier. Some contributin factors to volatility include unforeseen clinical events, competitive news, FDA regulatory actions, financial news, and legal activities potentially involving celebs like Martha Stewart. The best use of shorting is when hedging a large portfolio of biotech stocks such as shorting the IBB index. Also shorting overvalued biotech stocks during a raging bull market can be profitable but that requires nerves of titanium and ample capital as institutions can drive their favorites by another 50% or more before reality sets in and the stocks goes into free-fall. One of the greatest biotech shorts of all time Ventro (VNTR) in 1999-2001 soared from 25 to 140 before disappearing into bankruptcy. Yes, you may have known the business model was doomed but try holding on to the short stock as it goes from 80 to 130.

Trading and Analysis Tools

With the availability of the Internet research sites such as Yahoo Finance, Nasdaq.com, ClearStation and the information provided by brokerage firms, tools are readily available to do stock and portfolio analysis.
Some of the key parameters are as follows:

Technical Analysis – Using charting and trading patterns including seasonality, to time the entry or exit points.

Fundamental Analysis – Analysis of the balance sheet, income statement, and news. This news is readily available on the Internet and in SEC filings from sources such as Edgar Online and 10K Wizard.

Clinical development portfolio – Analysis of what products are in the pipeline. This can be found by reading company reports and related regulatory filings

Institutional activities – An understanding of what market makers are doing can be gained by watching analyst recommendation and trading activities by large mutual and hedge funds . A handy place to look for this kind of information is the Nasdaq site, where institutional positions and fund ownsherhip statistics in individual stocks are listed quarterly.

How to Value Biotechnology Companies

Unfortunately the standard financial metrics do not always apply except to the “top -tier’ biotech companies that have large revenues and/or earnings. With those companies one can look at Price/Sales ratio, P/E ratio, Balance Sheet, technical trading patterns and earnings growth.

Analysis that is used by Wall Street “sell side” firms typically includes a pro-forma forecast of revenues from the current product portfolio that is in various stages of clinical trials. Assumptions would include approval dates, partnerships with larger pharmaceutical firms and product revenues. From the product portfolio a discounted cash flow analysis (DCF) is done forecasting product sales, and values the Company at a future hypothetical PE and PS.

Without the benefit of an analysts’ product portfolio or forecast, the following guidelines may be used to make a quick fundamental valuation of a Company:

Cash position and years of cash burn. A development stage company without revenues should have at least two years of cash and more in bear markets. Review balance sheet carefully.

Product portfolio and clinical trial staging. A more difficult analysis is to review and value the clinical stage pharmaceutical products especially those in Phase III and II and make a judgement on the product sales. Anticipated product approvals drive stock prices several months in advance. There may be a sell on the news.

Institutional support and pedigree. If the major owners of the companies’ stock include strong investors , then there is hope that with good news the stock will be driven up. In bad times the company will be supported with a financing to protect VC investment. Of course this can also create volatility because the stock can be sold aggressively by institutions with bad news.

Management Team. Check out the bios of management to determine if their track record includes past successes and relevant experience.

Summary

Here is a preliminary guide for biotech investing:

Decide on biotechnology portfolio allocation and track monthly versus your technology holdings. Sell any losers that have declined more than 20%.

Initially start with a mutual/index fund and a few high quality stocks or a financial adviser who may have expertise in the area. See charts and holdings IBB and BBH.

Diversify portfolio with large caps, growth, value and speculative small caps.

Begin tracking your positions with some of the tools referred to in this article.

Don’t add to long term positions in frothy MO driven markets unless you are trading. Use stops and portfolio cutbacks on MO shifts of more than 20%.

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About the Author

Rod Raynovich is the founder of Raygent Associates, a management consulting firm providing business development and strategic marketing services in the life science and medical device area. He publishes his thoughts and analysis on the biotech industry at www.raygent.com.